A Fundamental Look at Technical Analysis

By John Arnopp
Analyst, mPower

Investors might prefer tea leaves

When investors consider buying a stock, one of the first things they review is whether or not the share price is worth it. Individual investors have many methods of stock picking, whether it be expert advice, personal research, or gut instinct, but one research method that often mystifies the regular investor is technical analysis.

Using this approach, analysts value stocks and determine the best time to buy. The primary tool of technical analysis is charted data showing volume, price, and other indicators related to the stock. Often, this method seems as bewildering to investors as reading tea leaves, but it can help to remember that technical analysis is often thought of as the antithesis to "fundamental analysis," which looks at individual company and industry characteristics.

The lineage of technical analysis

Dow Theory, developed by Dow Jones & Co. co-founder Charles Dow around the turn of the last century, is the precursor to most of today's technical analysis. Dow focused on security price movements (specifically the Dow Jones Industrial Average). This was a completely new method of analyzing markets, and discounted every other market factor including the collective knowledge and expectations of all other market participants. Investors use Dow theory in an attempt to identify broad trends (usually lasting years) and short-term movements (lasting from weeks to months).

The technical analyst, or "chartist," believes that current price movements can help predict future price movements. Chartists believe that price trends reflect investor expectations, be they bullish or bearish.

Indeed, looking at the charts here, several different analysts might come to several different conclusions, each of them "obvious" to the specific analyst (but not necessarily to anyone else).

Technical analysts would say that chart patterns represent the psychological aspect of the market participants - human beings - who behave in a non-rational fashion based on a trend mentality. However, in practice, the predictive value of this system is not as obvious. Many chartists attribute a less than stellar track record to mistakes in reading the charts, or to a false trend that did not develop. Of course, these are conclusions known after the fact.

The wave of the future

Another technical analysis technique includes looking at numeric patterns, or waves. This is exemplified by the "Elliot Wave Theory," which seeks to identify repetitive patterns stock market prices supposedly exhibit.

The Elliot Wave Theory The numerical foundation for much of Elliot's work is the Fibonacci Series, which is obtained by starting with 1 and adding the previous number to it (e.g., 1, 1+1=2, 2+1=3, 3+2=5, 5+3=8, etc.). You can see that trying to identify and fit a pattern like this from a chart of daily price movements could turn into a full-time job.

Beyond applying mathematical theories, technical analysis can be seen in action in Internet chat rooms. Visitors throw around a lot of jargon, leaving the impression that being a good chartist may be harder than learning the more accessible language of fundamental analysis. For example, the other day I wandered down a dark URL and stumbled upon these postings:

• Bonds have broken through a technical resistance level in yield, but believe it or not they are not oversold...
• Could anyone out there direct me to a good on-line explanation of Parabolic SAR?
• Notice that while the trending portions were captured well, the system whipsawed constantly during the sideways, nontrending periodS...
• I thought TA was supposed to take the emotion out of trading? I'm hoping I'll get better with experience.

Getting down to fundamentals

In contrast to technical analysis, fundamental analysis is based on the belief that stock has value arrived at by examining characteristics such as revenue, expenses, earnings growth, and other material data. These factors are carefully adjusted, evaluated, and discounted. The analyst then determines valuations based on the above characteristics. For example, a "forward P/E" ratio is a stock's price-to-estimated earnings.

Fundamental analysts then compare these figures with the valuations of other firms in the same industry, and evaluate results to see which firms are relatively cheap and which are relatively expensive. Fundamental analysis then discounts a firm's future earnings power by some rate of return, in order to arrive at a fair current price.

The fundamental process is detailed and logical, and based almost entirely on the belief that all other market participants (or the vast majority of them) are using the same logical techniques to evaluate prices. There is little or no room for the psychological factors that are so important to the chartist.

In general, most people tend to feel more comfortable with a complete fundamental analysis that takes into account multiple characteristics of a business, rather than pure technical analysis. In practice, many analysts use a combination of both techniques to make investment decisions.

Never mind - give me a dart board

There is another theory that should be mentioned here. "Efficient Market Theory" holds that everything there is to know about the future of a firm is already reflected in its security price. This includes all known future developments, including investor expectations, management ability, and even insider information.

Efficient Market Theory Efficient Market Theory was proposed by Eugene Fama and Kenneth French, and popularized by Burton Malkiel in A Random Walk Down Wall Street.

Efficient market theory suggests that the chartist is wasting time looking at past prices, and that the fundamental analyst couldn't arrive at any better estimate of current value or mispricings, since everything is already fairly valued in the price.

Investors following this theory would simply buy a diversified basket of securities (a "market portfolio") with the expectation of capturing the market return. This has led to the notion that by throwing darts at the stock listings, an investor can do as well as the "experts" in selecting successful investments.

Don't quit your day job just yet

If this is true, why do technical and fundamental analysts still have jobs? Because they are the ones providing the information that could create an efficient market. With legions of analysts reviewing fundamental, psychological, numerical, and even astrological factors, prices can reflect all available knowledge, and perhaps do reflect an efficient market. If at any time there is information available to one person or group and not to another, there is an opportunity for profit from this information.

Of course, new information is constantly being discovered, and subsequently some profit is made, but as soon as an investor tries to take advantage of information the fact remains that they are buying (or selling) tips off other traders ¾ and novel opportunity can quickly dissipate.

Fundamental analysis is often thought of as having an edge over the purely technical approach, but most large brokerages and money managers will use a combination of both, with an emphasis on the fundamental.

Even so, I predict the chat rooms and proprietary trading systems will not likely vanish soon. The best research method for a regular investor is to be an informed market participant. This involves knowing what you're investing in, and how this investment serves you.

Note: 401k Forum, LLC, which publishes the 401Kafé, employs a fundamental approach to investing. As an advisor on long-term investing strategy, 401k Forum believes that the risks outweigh the potential benefits from possible short-term tactical movements based on very short-term technical indicators."

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

A Fundamental Look at Technical Analysis

By John Arnopp
Analyst, mPower

Investors might prefer tea leaves

When investors consider buying a stock, one of the first things they review is whether or not the share price is worth it. Individual investors have many methods of stock picking, whether it be expert advice, personal research, or gut instinct, but one research method that often mystifies the regular investor is technical analysis.

Using this approach, analysts value stocks and determine the best time to buy. The primary tool of technical analysis is charted data showing volume, price, and other indicators related to the stock. Often, this method seems as bewildering to investors as reading tea leaves, but it can help to remember that technical analysis is often thought of as the antithesis to "fundamental analysis," which looks at individual company and industry characteristics.

The lineage of technical analysis

Dow Theory, developed by Dow Jones & Co. co-founder Charles Dow around the turn of the last century, is the precursor to most of today's technical analysis. Dow focused on security price movements (specifically the Dow Jones Industrial Average). This was a completely new method of analyzing markets, and discounted every other market factor including the collective knowledge and expectations of all other market participants. Investors use Dow theory in an attempt to identify broad trends (usually lasting years) and short-term movements (lasting from weeks to months).

The technical analyst, or "chartist," believes that current price movements can help predict future price movements. Chartists believe that price trends reflect investor expectations, be they bullish or bearish.

Indeed, looking at the charts here, several different analysts might come to several different conclusions, each of them "obvious" to the specific analyst (but not necessarily to anyone else).

Technical analysts would say that chart patterns represent the psychological aspect of the market participants - human beings - who behave in a non-rational fashion based on a trend mentality. However, in practice, the predictive value of this system is not as obvious. Many chartists attribute a less than stellar track record to mistakes in reading the charts, or to a false trend that did not develop. Of course, these are conclusions known after the fact.

The wave of the future

Another technical analysis technique includes looking at numeric patterns, or waves. This is exemplified by the "Elliot Wave Theory," which seeks to identify repetitive patterns stock market prices supposedly exhibit.

The Elliot Wave Theory The numerical foundation for much of Elliot's work is the Fibonacci Series, which is obtained by starting with 1 and adding the previous number to it (e.g., 1, 1+1=2, 2+1=3, 3+2=5, 5+3=8, etc.). You can see that trying to identify and fit a pattern like this from a chart of daily price movements could turn into a full-time job.

Beyond applying mathematical theories, technical analysis can be seen in action in Internet chat rooms. Visitors throw around a lot of jargon, leaving the impression that being a good chartist may be harder than learning the more accessible language of fundamental analysis. For example, the other day I wandered down a dark URL and stumbled upon these postings:

• Bonds have broken through a technical resistance level in yield, but believe it or not they are not oversold...
• Could anyone out there direct me to a good on-line explanation of Parabolic SAR?
• Notice that while the trending portions were captured well, the system whipsawed constantly during the sideways, nontrending periodS...
• I thought TA was supposed to take the emotion out of trading? I'm hoping I'll get better with experience.

Getting down to fundamentals

In contrast to technical analysis, fundamental analysis is based on the belief that stock has value arrived at by examining characteristics such as revenue, expenses, earnings growth, and other material data. These factors are carefully adjusted, evaluated, and discounted. The analyst then determines valuations based on the above characteristics. For example, a "forward P/E" ratio is a stock's price-to-estimated earnings.

Fundamental analysts then compare these figures with the valuations of other firms in the same industry, and evaluate results to see which firms are relatively cheap and which are relatively expensive. Fundamental analysis then discounts a firm's future earnings power by some rate of return, in order to arrive at a fair current price.

The fundamental process is detailed and logical, and based almost entirely on the belief that all other market participants (or the vast majority of them) are using the same logical techniques to evaluate prices. There is little or no room for the psychological factors that are so important to the chartist.

In general, most people tend to feel more comfortable with a complete fundamental analysis that takes into account multiple characteristics of a business, rather than pure technical analysis. In practice, many analysts use a combination of both techniques to make investment decisions.

Never mind - give me a dart board

There is another theory that should be mentioned here. "Efficient Market Theory" holds that everything there is to know about the future of a firm is already reflected in its security price. This includes all known future developments, including investor expectations, management ability, and even insider information.

Efficient Market Theory Efficient Market Theory was proposed by Eugene Fama and Kenneth French, and popularized by Burton Malkiel in A Random Walk Down Wall Street.

Efficient market theory suggests that the chartist is wasting time looking at past prices, and that the fundamental analyst couldn't arrive at any better estimate of current value or mispricings, since everything is already fairly valued in the price.

Investors following this theory would simply buy a diversified basket of securities (a "market portfolio") with the expectation of capturing the market return. This has led to the notion that by throwing darts at the stock listings, an investor can do as well as the "experts" in selecting successful investments.

Don't quit your day job just yet

If this is true, why do technical and fundamental analysts still have jobs? Because they are the ones providing the information that could create an efficient market. With legions of analysts reviewing fundamental, psychological, numerical, and even astrological factors, prices can reflect all available knowledge, and perhaps do reflect an efficient market. If at any time there is information available to one person or group and not to another, there is an opportunity for profit from this information.

Of course, new information is constantly being discovered, and subsequently some profit is made, but as soon as an investor tries to take advantage of information the fact remains that they are buying (or selling) tips off other traders ¾ and novel opportunity can quickly dissipate.

Fundamental analysis is often thought of as having an edge over the purely technical approach, but most large brokerages and money managers will use a combination of both, with an emphasis on the fundamental.

Even so, I predict the chat rooms and proprietary trading systems will not likely vanish soon. The best research method for a regular investor is to be an informed market participant. This involves knowing what you're investing in, and how this investment serves you.

Note: 401k Forum, LLC, which publishes the 401Kafé, employs a fundamental approach to investing. As an advisor on long-term investing strategy, 401k Forum believes that the risks outweigh the potential benefits from possible short-term tactical movements based on very short-term technical indicators."

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.